The case for taxing real “Value Added” – not VAT!

ECONOMIC PERSPECTIVES – 57

Considering the UK’s horrendously complex tax system, have you noted the competitive strategies for tax reform put forward by Tory candidates in their bid for election to high office?

Most of their suggested “reforms” involved some judicious cutting of tax rates; or shifting of tax burdens; or adjusting thresholds to give relief to favoured sectors; and so on. But amid these bids for popular appeal there was scant recognition of this most basic principle: income belongs to those who earn it, and the aim of any Chancellor should be to take from them only what is necessary to finance the legitimate and necessary expenses of the state.

As we know, while still in the race Michael Gove put forward the idea of replacing VAT with a straightforward Sales Tax on goods and services. I assume he realises that VAT is a Sales Tax anyway – in which case the only merit in Gove’s proposal is that the VAT version of this tax is unnecessarily complex, involving businesses and HM Customs with tiresome paperwork on assessments, exemptions and rebates as the dreaded impost is passed on down the chain of intermediate businesses, only to finish up, ludicrously and paradoxically, taxing the sole participant in the chain who adds no value – the ultimate consumer!

Gove’s proposed Sales Tax would therefore simplify matters by cutting out all those intermediate plusses and minuses and associated form-filling; but its incidence – where it ultimately falls – would be exactly the same as VAT; while, as a tax, it would suffer from the same defects as VAT: it would still cause price inflation by pushing up the cost of goods and services by the amount of the tax; it would relieve the tax authorities of the task of tax-collection, shifting it onto business; and it would be wholly indiscriminate in its incidence, penalising people without reference to affordability. Thus, as a tax, it would on several grounds offend Adam Smith’s fundamental “canons” of taxation.

What’s in a name?

But here’s the surprise. For me, the chief merit in abolishing “Value Added Tax” would be getting rid of the deceit implicit in its name, for the one thing VAT is not is a tax on value added! To understand why this matters, it is necessary to know what “value added” actually is, and why a tax on real value added would be a brilliant tax, an all-round winner.

So, what is “value added”?

Value that is “added” by a business can be precisely measured by deducting from its sales revenue the cost of goods and services “bought in” from its suppliers (thus forming part of their “sales” revenue).

This is simple enough, both as a concept and as a calculable amount, but somehow people still find it confusing.

For example, on being shown this definition, many of my students have retorted “but surely that’s just the same as gross profit!”

Well, no. It is not the same as “gross profit”, which is an accounting term connoting total revenue minus the costs directly associated with earning that revenue. The glaring difference between value added and gross profit becomes obvious when you consider the accounting treatment of production costs such as manufacturing wages.

To arrive at gross profit, manufacturing wages – like any other direct cost – are simply deducted from revenues. Now look again at the definition of value added.Wages are not “bought-in” from external suppliers; therefore they are NOT deducted from revenues when calculating value added. Indeed, wages represent the return to labour as a factor of production. They are a distribution of value added, not a cost!

Correctly understood, therefore, the value added by an enterprise is the product of conjoint inputs from the factors of production (land, labour and capital), coming together in that nexus, the business enterprise. Value added is its output, and as such it represents the contribution of that enterprise to the national product.

Value Added as the Tax Base

As a tax base, the value added by a business is a far more equitable target for taxation. Let me explain.

In general, the value added of enterprises will be relatively higher, or lower, depending on where they are located; how proximate they are to the markets they serve; and the availability of transport and other amenities that provide access to those markets and the community at large. It’s obvious that the presence of the community itself adds wealth.

Take an example. London’s Jubilee Line cost £3.5 billion to construct; yet, once created, it added £13 billion to the value of sites that benefitted from its presence. In effect, the presence of the community “added that value” of £10 billion. Since government exists for the benefit of the community that pays for its upkeep and support out of taxes, it is both logical and equitable to cut all the convoluted crap, and allow the value added by that community to be the subject of taxation, levied as a tax on value added [or, directly, as a tax on site values].

A low percentage of total value added would fall well within the capacity of enterprises to bear it, would be a major contributor to the nations coffers, and would replace any number of counterproductive imposts – including the pernicious taxes on employment that cause unemployment, that are inflicted by successive Chancellors in their ignorance.

I emphasize the word “low” because the surest spur to creating greater wealth for the whole community is to reduce the existing burdens of business rates and corporation tax.

This is all so very obvious – but it’s probably far too simple for policy- makers to follow – especially if their brains are already too addled with serpentine complexity!

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